OCC warns about increasing credit risk
Speaking last week to the Exchequer Club, Curry said, “It’s the point in the cycle where we customarily see an easing of loan underwriting standards, as banks drop or weaken protective covenants, extend maturities, and take other steps to build market share.” During this time, banks are also prone to developing larger loan concentrations, he said. “It’s a natural byproduct of competition during the later stages of the economic cycle, and so it’s a time when supervisors and bank risk officers need to be most vigilant.”
With the industry seemingly trending up – commercial and industrial loans, for example, have increased for more than four straight years – Curry warned that it may be a “misleading indicator of the fundamental health of the banking system.” He added, “Credit quality, after all, reflects the outcome of decisions made when loans are originated, perhaps months or years earlier, possibly under tougher standards than those in effect today.” Consequently, banks won’t know the results of those decisions until months or years down the road. To help mitigate the increased credit risk, banks need to have appropriate risk management processes, including the ability to measure, monitor and control the risk, according to Curry.
One area of credit risk that is concerning to the OCC is auto lending, which has been steadily growing in recent years. In fact, Curry noted that at the end of the second quarter of 2015, “auto lending represented more than 10 percent of retail credit in OCC-regulated institutions, up from 7 percent in the second quarter of 2011.” In addition, more banks are packaging auto loans into asset-backed securities as opposed to holding them in a portfolio.
Curry pointed out that this trend is reminiscent of what happened in mortgage-backed securities leading up to the recession, where lenders “fed investor demand for more loans by relaxing underwriting standards and extending maturities.” He noted that 30 percent of new auto loans have maturities of more than six years, and borrowers are able to obtain car loans with low credit scores. “With these longer terms, borrowers remain in a negative equity position much longer, exposing lenders and investors to higher potential losses.” While delinquency and losses are low now, there’s certainly no guarantee it will last.
In spite of his concern related to auto loans, Curry pointed out that most asset classes are not inherently unsafe. “However, what is inherently unsafe are excessive concentrations of any one kind of loan.” Concentrations, whether they’re in residential real estate, agriculture or oil and gas, have played a role in bank failures and systemic breakdowns, he added.
With the potential risks outlined, institutions should prepare strategies to mitigate risks inherent to their portfolios. Whether it be upholding underwriting standards, avoiding heavy concentrations or stress testing the loan portfolio, institutions have the ability to guard against credit risk, pass examinations and continue positive growth.
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